Water-Backeds Could Gush, if U.K. Regulator Washes its Hands

The water industry could be the next big issuer of securitizations in the U.K. But if water companies are going to be able to issue deals they may need to convince regulators that doing so will be in the interests of the industry as a whole.

The water regulatory body Office of Water Services (Ofwat) has made it clear that it is concerned about the possibility of securitization, following recent market rumors that both United Utilities and Severn Trent are weighing up possible secured bond issues.

Those worries may have been increased by the news that Nomura's Private Finance Group has put in a GBP402 million ($606 million) bid for Welsh water and electricity company Hyder, given the PFG's past aggressive use of securitization as an exit strategy from its principal positions.

European utility businesses - including gas, water, electricity, waste management and telecoms - are increasingly being exposed to the pressures of competition as a result of domestic and European Commission guidelines. Many of these companies, formerly state-owned, no longer have the security provided by government funding and are having to look to alternative sources of finance.

A recent Ofwat report estimated that U.K. water companies need to raise GBP15 billion over the next five years to finance their capital spending programs. At the same time, companies are having to adjust to new price limits imposed by Ofwat, which came into effect on April 1, and mean that for the first time they will have to reduce their prices.

The new price limits are already having an affect on companies' profit margins: Severn Trent's profits for the first quarter this year fell to GBP274 million from GBP350 million in the corresponding period last year, for example.

Nonetheless, the company is looking to expand its business and, having recently bought UK Waste for GBP380 million, is also looking at buying Swedish waste management company, WM Sellbergs. This has led to the speculation that it may be on the lookout for a securitization of future receivables to finance its expansion plans.

Allan Costin, group finance director at Severn Trent, admitted that the company was looking at securitization but believed that a lot of work needed to be done before it became a possibility.

"Securitization is a hot topic in the water sector and we've said that this is something we're looking at, but it's no more than that at this stage," he said. "There are some obvious attractions, but equally there are some difficulties and hurdles that need to be overcome before it can made to work in a way that creates value for shareholders. We are looking at it in some detail, but we haven't made our minds up yet."

The water companies have already raised significant funding though unsecured corporate bonds. Severn Trent, for instance, raised GBP600 million in 1999 with two separate long-dated issues.

One of Ofwat's principal concerns is that investors in such deals could be adversely affected - through subordination - if companies were now looking at issuing secured bonds.

"We have been approached by investors and institutional bond holders, to say they were concerned about existing debt being subordinated if a securitization issue was to take place," said an official in Ofwat's corporate finance division. "They were looking particularly at a company like Nomura coming into the U.K. market, because they have used this tool in the past."

The official added that Ofwat did not have a problem with the securitization concept, but wanted to ensure that investors in corporate bonds did not lose out if the performance of those deals suffers thanks to any ABS issues. "Our particular view is that if companies can find more efficient financing, that's great, but our concern is that this shouldn't affect the bond market [for water companies] as a whole," he said. "That might happen if existing bondholders got their fingers burnt, because they'd be less interested in any future issues."

Ofwat has no direct powers to block deals, but can put pressure on companies if it sees fit. "There is no particular power to prevent securitizations, but the director general has to act in the best interests of the industry," the official said. "He may say that it is against those best interests if the companies, by their actions to get a good deal now, implicitly raise the cost of funding in later years, and shouldn't expect Ofwat to bail them out with lower price caps."

Costin shares some of Ofwat's concerns, but ironically, it is the increasing costs of raising finance in the corporate bond market that could drive Severn Trent towards a securitization. "Ofwat have a valid point. There is no doubt that the bondholders for bonds currently in existence are seriously concerned that their position is subordinate to bonds under a securitization," he said. "That has led to a widening on water company spreads generally, which means that if a company wanted to issue a long-dated corporate bond now, it would be very expensive and difficult to launch another issue into this market."

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